Jesse's Café Américain

The London Banker has an interesting blog, and for some weekend reading we offer his latest piece on Irving Fisher's Theory of Economic Depressions, excerpt and link.

Mr. Fisher is a bit neglected these days, having made himself look the fool on the occasion of the Crash of 1929 and several times thereafter with optimistic pronouncements that in retrospect are incredibly embarrassing, severely tarnishing his reputation, perhaps deservedly so. but overshadowing some finer work in other periods of his career.

Is this perhaps why so many economists not in the employ of large trading houses and the government are so silent on the things that matter these days, with a few notable exceptions which will certainly be remembered favorably?

Nevertheless, the London Banker's views on this are worth reading, carefully and thoughtfully. It is a little disappointing in that he does not spend more time bringing Fisher's theory up to date. In particular, it is important to remember that Fisher was still thinking in terms of a currency constrained by an external standard for money, even though the dollar was substantially devalued in 1933.

We are seeing a replay of the elements which created the Crash and Great Depression complete with Fed policy errors and a complacent public, but played out under a purely fiat monetary regime. Exogenousl restraints may not limit the expansion of the dollar, providing new possibilities and variations on a theme. A brave New World indeed.

Those who are thinking of the scenario in which the US dollar gains in value during a debt deflation are imagining the dollar as a commodity rather than a currency.

As a commodity in short supply, they believe that the dollar will become more valuable because of some imagined constraint in its production by the Fed, tied to the creation of new credit. The average mind rebels at what a fiat currency actually represents.

They place too much emphasis on a fiat currency as a store of value, rather than its primary function as a medium of exchange. As a store of value the dollar is, and has been, and will be a wretched performer over all but the short term in special situations.

Another British economist Peter Warburton published in 1999 a more expansive view of this in a book that has become a cult classic, Debt and Delusion: Central Bank Follies that Threaten Economic Disaster.

In his April 2001 essay, The Debasement of World Currency: It Is Inflation, But Not As We Know It
Warburton noted:

"What we see at present is a battle between the central banks and the collapse of the financial system fought on two fronts. On one front, the central banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur. On the other, they incite investment banks and other willing parties to bet against a rise in the prices of gold, oil, base metals, soft commodities, or anything else that might be deemed an indicator of inherent value. Their objective is to deprive the independent observer of any reliable benchmark against which to measure the eroding value, not only of the U.S. dollar, but of all fiat currencies. Equally, their actions seek to deny the investor the opportunity to hedge against the fragility of the financial system by switching into a freely traded market for non-financial assets."

Thursday, 31 July 2008
Fisher's Debt-Deflation Theory of Great Depressions and a possible revision
The London Banker

“Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”. John Stuart Mill
I have been both a central banker and a market regulator. I now find myself questioning whether my early career, largely devoted to liberalising and deregulating banking and financial markets, was misguided.

In short, I wonder whether I contributed - along with a countless others in regulation, banking, academia and politics - to a great misallocation of capital, distortion of markets and the impairment of the real economy.

We permitted the banks to betray capital into “hopelessly unproductive works”, promoting their efforts with monetary laxity, regulatory forbearance and government tax incentives that marginalised investment in “productive works”.

We permitted markets to become so fragmented by off-exchange trading and derivatives that they no longer perform the economically critical functions of capital/resource allocation and price discovery efficiently or transparently.

The results have been serial bubbles - debt-financed speculative frenzy in real estate, investments and commodities....

Fisher's Debt-Deflation Theory of Great Depressions and a Possible Revision - The London Banker